February Business First: Rethinking Nonprofit Business Theory

Early in 2012, the nonprofit world was shocked by the bankruptcy filing of Hull House, a storied 123-year-old social services nonprofit. Frankly, it was inevitable.

A colleague recently brought to my attention a very useful quote by Peter Drucker from a 1994 Harvard Business Review article:

What underlies the current malaise of so many large and successful organizations is that their theory of the business no longer works. The assumptions on which the organization has been built and is being run no longer fit reality….Some theories…are so powerful that they last for a long time. Eventually, every theory…becomes obsolete and then invalid. When a theory shows the first signs of becoming obsolete, it is time to start rethinking the theory.

That is precisely what went wrong with Hull House. Over the past 25 years, the number of nonprofits grew threefold in the United States, and the nonprofit business model moved sharply toward being a contract provider of government services. Philanthropy filled the gap between what the government would pay and what it cost to provide the services.

This strategy worked well in the 1990s and into the last decade. More nonprofits were created each year. More government services were contracted out to nonprofits. Government payments persisted below nonprofits’ costs, and contributions managed to keep pace, filling the gap.

But the assumptions of this business model no longer fit reality.

The future theory of nonprofit business needs to recognize the reality that earned revenues have always been the primary source of nonprofit income. The most recent data from the Internal Revenue Service show that earned revenue constitutes 77 percent of nonprofit income. This share varies by the type of nonprofit, but it falls below 50 percent only in two sectors – education (sans higher ed) and the arts, culture, and humanities sector. The former still earned a significant 43 percent of its revenues and the latter a much smaller 29 percent. Even the human services sector raised more revenue through fees and contracts than it raised through contributions.

Earned revenues need to remain the majority of nonprofit revenues, but they must come increasingly from non-government customers. Additionally, government contracts that nonprofits do accept must come with terms that are closer to covering the true cost of services.

As Drucker wrote so long ago, it is time to start rethinking the theory of the nonprofit business.

If you are interested in reading more on this topic, my article in Columbus Business First is out this Friday, February 24. I look forward to your comments and feedback.